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Vital Images Inc. (NASDAQ:VTAL)

Q4 2008 Earnings Call

February 19, 2009 11:30 am ET

Executives

Mike Carrel – President & Chief Executive Officer

Peter Goepfrich – Chief Financial Officer

Analysts

Michael Cherney – Deutsche Bank

Charles Rhyee – Oppenheimer & Co.

Richard Close – Jefferies & Co.

Ernest Andberg – Feltl & Co.

Brett Jones – Leerink Swan

Alan Fishman – Thomas Weisel

Operator

Good day ladies and gentleman and welcome to the Vital Images fourth quarter earnings conference call. (Operator Instructions). I would now like to introduce your host for today’s conference call, Mr. Mike Carrel.

Mike Carrel

Thank you, Mike. Good morning and welcome to our fourth quarter and full year conference call. With me today is Peter Goepfrich, our Chief Financial Officer. Before we begin, I must preface all comments with the safe harbor statement.

Some of the comments made today will be forward-looking and made under the Private Securities Litigation Reform Act of 1995. Actual results may differ and factors that may cause such results to differ are identified on page ten of our Form 10-K for the year ended December 31, 2007.

A year ago, our board asked me to lead our company, and what a year it has been. We have seen tremendous changes in our company, our market, and of course, in the world around us. Let me begin today with an overview of our performance and an update on our transition towards the Enterprise model.

This morning we reported fourth quarter revenue of $17.4 million, up from $16.7 million in the same period last year. International sales and maintenance and services revenue were especially strong. We also generated $2.2 million of cash flow from operations and $8.6 million for the full year.

Our bottom line was better than expected. Given difficult market conditions, we are pleased with our performance and year-over-year growth. The company is in an excellent financial position and when the markets improve, we will be ready to resume strong growth.

We are making progress on our plan to transition the company to being a true Enterprise Software provider. In fact, in the fourth quarter we closed seven sizable transactions of over $350,000. Not only are these kinds of large transactions at some of the leading hospitals and hospital systems around the world, but each enterprise customer whether it is a large deal or a small deal offers an opportunity for substantial recurring revenue in the form of maintenance, and other services.

Most of these deals were won as a result of our offering VitreaWeb, the solution that we rolled at RSNA in November that allows for full access to all of our applications over the internet. We now have an install base of more than 3,500 customers, a strong barrier to entry, as well as an important platform for future growth.

Vital is gaining significant share from our competitors. Our nearest competitors all declined over 30% in 2008 based on the independently verified data that we have gathered. With a loyal global customer base, stream lined operations and talented engineering team, we are well positioned to weather the current economic situation and achieve our goals.

In 2008 we rose to the challenge and completely revamped our pricing, service and business model for the larger enterprise. In fact, globally over the last year we closed more than ten significant transactions, including many with our ViTAL Enterprise or VitreaWeb Solutions, each poised to generate substantial recurring revenue streams for the business.

Examples include: LA County, Park Nicollet in Minneapolis, The University of Southern California, Lee Memorial in Florida, Southwest General in Cleveland, Brigham and Women’s in Boston, Sharp HealthCare System in San Diego, Detroit Medical System.

In addition, we closed sizable transactions and deals with two customers in Northern Ireland and Switzerland. While much remains to be done and the overall decline in the imaging market and health care capital spending and the broader economy significantly impacted top line growth for the industry, I cannot overstate the importance of our Enterprise strategy and our continued focus on great clinical applications and utilization everywhere.

As markets have soured, we remain as the player best positioned to come out on top because of our Enterprise model and superior technology. Last year we made great strides in our products as well. Our new data management capabilities are a huge differentiator.

At RSNA, we launched access everywhere with VitreaWeb and with Vitrea FX 2.0 for Toshiba and the work station market. VitreaWeb is a spectacular demonstration of how we deliver value to the enterprise and it was a big hit at RSNA.

It is truly the best product on the market today. During our implementation since then, such as the one done this week at Medical Diagnostic Imaging Group, we hear things such as “VitreaWeb is outstanding, the speed and capabilities are incredible.”

Additionally, in a recent independent survey of all U.S. hospitals of over 100 beds, Vital was ranked number one in market share, best technology, best vendor to work with, and most improved technology in 2008, over our most direct competitors including General Electric, Terra Recon, Siemens, and Phillips.

We are both humbled and proud of this recognition to provide improved patient care for our customers. In 2009 in an effort to further distance ourselves from the competition and take advantage of our strong financial standing, we will continue to invest in research and development and set the stage for truly game changing transformations in 2010 and beyond.

I’ve spoken many times about the importance of world class people in building a world class organization. The rapid changes in our company have opened opportunities to develop and recognize the many talents at Vital.

In 2008 at the executive level, Peter Goepfrich moved into his new role as CFO, Steve Canakes took over International Operations; Steve Andersen shifted his focus to our number one customer, Toshiba, and Ian Nemerov, our General Counsel, now oversees Quality and Regulatory.

Additionally, a great company cannot succeed without attracting new talent from the outside. We are fortunate in 2008 to bring Vikram Simha back home to Vital Images as our CTO, and hired Ray Ghanbari to drive our marketing and growth strategies.

Other 2008 highlights include significant cash flow from operations $8.6 million for the year, with – and ending the year with $147 million in cash, even after spending $38 million on our stock buyback, customer coverage for worldwide maintenance and services of approximately 70%, our direct bookings in Europe trended up all year, the signing of a five-year commitment on the distribution side of the relationship with Toshiba and the signing of our first ever development agreement with Toshiba in January 2009.

Winning the Frost & Sullivan award for Innovation in Medical Informatics, establishing key European alliances with [Sectura] and [Telemise] in France, right-sizing the business in preparation for improved financial performance in 2009 and beyond, and almost doubling our sales pipeline line over the last year in a very difficult market

As much progress as we’ve made in 2008, there is much more to come in 2009 and the future. By strengthening our core business and technology platforms, we are creating the capacity for big moves that will fundamentally alter our company beyond 2009. I’ve never been more excited about the future of Vital Images. We have the financial, intellectual and relationship capital to redefine and drive the market turnaround for our industry.

We are focused on growth and adjusted EBITDA profitability and cash flows in 2009. While this year will continue to be – will be tough from a market perspective, we will emerge even stronger when the market improves. Now I’ll turn it over to Peter to discuss the fourth quarter results.

Peter Goepfrich

Thank you, Mike. I want to comment on a few key items in yesterday’s earnings release. Fourth quarter revenue was $17.4 million, up from $16.7 million in the fourth quarter last year. Fourth quarter net loss was $386,000 or $0.03 per diluted share, improved from a net loss of $1.6 million or $0.09 per diluted share in the fourth quarter last year.

The decrease in interest rates over the past year has had a significant impact on our results year-over-year. Interest income was $787,000 in the fourth quarter in 2008, compared to $2.2 million in the fourth quarter of 2007.

Our return on investments had decreased to 2.1% in the fourth quarter of 2008 from 4.9% in the fourth quarter last year. Adjusted EBITDA, a non-GAAP measure, was $1.2 million, an improvement over a loss of $1.2 million in the fourth quarter last year.

The gain and adjusted EBITDA was primarily due to cost control measures initiated throughout the year, as well as the work force reduction announced in November 2008, which resulted in a $660,000 restructuring charge in the fourth quarter.

Fourth quarter gross margin was 75.4% compared to 77.5% in the fourth quarter last year. The decrease in gross margin was due to the increase in Toshiba International revenue, which carries lower margin as a percentage of revenue and the increase in ViTAL Enterprise revenue, which generally carries lower license fee gross margin because we defer more of an initial order for the first year of maintenance and services.

This results in a decrease in license revenue, but an increase in future maintenance and service revenue. The impact of these items was partially offset by a $391,000 benefit to maintenance and support revenue in the fourth quarter for Toshiba billing adjustments related to historic periods.

Next, let me give you an update on ViTAL Enterprise. During the fourth quarter, we closed $4.1 million in ViTAL Enterprise orders, which represented $1.9 million of license revenue. This is up sequentially from $2.1 million in orders, which represented $1 million in license revenue in the third quarter of 2008. License revenue related to ViTAL Enterprise has nearly doubled each successive quarter since its launch in the second quarter of 2008.

As I’ve noted over the past several quarters, as we transition to ViTAL Enterprise, the number of Vitreas, ViTALConnects, and options sold, is less meaningful and we will migrate away from such disclosure in 2009. That said, during the fourth quarter of 2008, outside of ViTAL Enterprise, we sold 183 Vitreas and 12 ViTALConnects.

Next, I want to review noteworthy operating expenses on a sequential basis that is compared to the third quarter of 2008. Fourth quarter sales and marketing expenses were $7.2 million compared to $7 million in the third quarter. The increase was primarily due to RSNA costs in the fourth quarter, offset by internal cost control measures, including work force reduction.

Fourth quarter research and development expenses were $3.9 million compared to $4.6 million in the third quarter. The decrease was primarily due to the work force reduction and lower consulting expenses.

Fourth quarter G&A expenses were $3.5 million or flat, compared to the third quarter. The impact of the work force reduction was offset by legal, audit, and other consulting fees. Total employee count was 280 as of December 31, 2008, compared to 320 as of September 30, 2008. During the fourth quarter, total sales force count, which includes sales management and sales operations, decreased from 62 to 52.

Now let’s turn to the balance sheet, which continues to be strong. As of December 31, 2008, we had cash, cash equivalents, and marketable securities of $147 million. The share repurchase program represented a decrease in cash of $12.8 million during the fourth quarter and a decrease in cash of $38.2 million during 2008. Excluding the share repurchase program, cash, cash equivalents, and marketable securities increased $2.1 million during the fourth quarter and $6.8 million during 2008.

The share repurchase program was completed in early February 2009. Through the program, we repurchased 2.9 million shares for $40 million, which represents approximately 17% of the shares outstanding prior to the implementation of the repurchase program.

Next, Mike will discuss other significant events from the quarter, as well as provide an update on our corporate priorities and Vital’s 2009 guidance.

Mike Carrel

As Peter noted, I want to share now the progress we’re making on our key strategic goals; first and foremost, our acceleration in accelerating our transformation to become an Enterprise Imaging Solution provider.

This process began in earnest in 2008 when we developed our Enterprise Model and retooled our solution pricing sales and service organizations for larger deals that integrate our solutions with health care systems PACS solutions and EMRs.

This is no small undertaking and we’ve said all along that this transition will take time. Enterprise transactions are far larger and involve more high level decision makers at the customers end. Positioning Vital for larger transactions with ongoing maintenance and services revenue streams is definitely the right thing to do.

We’re in the second year of a multi-year plan, proud of our progress, and are beginning to see some results. Everywhere our ViTAL Enterprise solution has been implemented, customers recognize its value. With our strategy to become an Enterprise Clinical Applications company, our sales pipeline is growing in both field size and in quality.

Second, building our next generation technology; we are creating a single Enterprise enabled platform to deliver applications and provide service excellence to the enterprise. Further, we will expand our clinical applications including the use of CAD for medical specialties and continually improve workflows.

In the fourth quarter as I noted earlier, we rolled out VitreaWeb, a big hit at RSNA. We provided a record 2,000 demonstrations even though total conference attendance was down due to the economy. Numerous customers told me, “VitreaWeb is exactly what we need.” This application enables all of our clinical applications on the web with seamless access from anywhere at anytime. VitreaWeb is an important step in improving efficiency for our customers, a key piece of our value proposition.

At RSNA, we also launched Vitrea FX 2.0, the next version of the software we developed for Toshiba and Toshiba scanners. Then last month, we signed a co-development agreement with Toshiba to advance our technology for Toshiba’s modalities. This agreement is in addition to our extended U.S. and international distribution agreement with Toshiba.

Our R&D priorities include executing on the road map toward one Enterprise enabled platform, expanding clinical application to cover more imaging modalities, inserting automation in CAD with more clinical work flows, enabling departments outside radiology to reap the benefits of advanced visualization, and measuring the operational efficiencies of our solutions.

Our third goal is to continue to gain market share in a tough market in the U.S. and internationally. We all know hospitals have been hit hard by the economic downturn. Credit is tight, admissions are down, and endowments have shrunk, resulting in equipment purchase delays. Further, 2008 CT sales were down more than 20% after a 32% decline in 2007, and the Deficit Reduction Act continues to restrain imaging related sales.

In many respects, do nothing is our biggest competition right now. We are confident that our strengths will carry Vital through this period. Vital has an incredibly large and loyal customer base and our Marquis customer program is developing important reference sites. Our Enterprise Model is building momentum and our sales and service staffs are gaining valuable experience working with Enterprise level customers.

Next, is the focus on the potential to expand and drive growth through mergers and acquisitions. In 2009, we will continue to look at acquisitions to expand our capabilities and accelerate our growth for the long term. Of course, any acquisition needs to be a strategic and financial fit before it makes sense. With $147 million in cash, we have the resources to pursue an acquisition and in this environment, opportunities are likely to emerge.

Now let me turn to our outlook. I cannot overstate how confidant I am in our new Enterprise approach and how the entire management team and I truly believe in the long-term market opportunities in front of us. Given today’s economic uncertainty, we expect to continue to feel the impact of the sluggish hospital spending due to the credit crunch, lower admissions, and overall economic weakness I talked about earlier.

While we cannot control the sluggish economy or the speed with which the CT and PACS markets will rebound, we are controlling what we can and thus, maximizing our operational efficiencies and cash flows. At the same time, we are committed to long-term growth, building the best products and solutions, and providing exceptional service. We intend to build on our technology and financial strengths in many ways.

So for guidance in 2009, as a general premise, the American Hospital Association recently issued a report saying that 45% of the hospitals in the U.S. have frozen spending in early 2009. Given these tough economic conditions, we are guiding for a decrease in revenue, but we are strong financially, gaining share, and are focused on growth and adjusted EBITDA profitability.

Our revenue estimates are $61 to $66 million, our adjusted EBITDA range is $2 million to $5 million, up from $1.8 million in 2008. Details and underlying assumptions are in the press release.

In summary, we made important progress in the fourth quarter and have an ambitious agenda for 2009 and beyond. There is no question that we are the strongest, nimblest player in the market, and I believe we are on the threshold of some great long-term prospects.

We remain committed to building and developing the best software solutions for the enterprise, taking exceptional care of our customers in the long-term growth and profitability in 2009.

Now we would like to turn the call over for questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). Our first question today comes from Michael Cherney – Deutsche Bank.

Michael Cherney – Deutsche Bank

So I just want to talk a little bit more about the general hospital environment, and what it means for you guys from a more of a long-term perspective. I don't think anyone on the call is surprised to hear that hospital CapEx trends remain difficult, but as you guys transform your business and make yourselves, for lack of a better term, more vitally important to the hospital itself, what does that mean in terms of your ability to eventually get towards meaningful profitability and cash flow?

Mike Carrel

When you say meaningful profitability and cash flow, maybe just clarify that and I can answer it a little bit more clearly.

Michael Cherney – Deutsche Bank

Just kind of steadier run rate on an EBITDA margin perspective, from – more in line with the peers versus where you guys are now.

Mike Carrel

We anticipate that as things turn around in the economy, we've put together and put in place from an operational standpoint that we have leverage in this business. We are continuing to invest in 2009. We could have gone even deeper from a profitability standpoint and gotten even more profitable in 2009, but we do believe that the investments we're making in building the platform and investing in service and having the sales force ready for when the market turns around.

We've got the ability to make leverage. We're a software company. We produce close to 80% margins. You'll see greater margins in 2009 than you saw in the fourth quarter, as Peter had mentioned, and so I think that as things begin to turn, we've got a tremendous amount of leverage in this business to drop more to the bottom line.

Michael Cherney – Deutsche Bank

Okay, and then just quickly. Obviously, there's been a lot going on in terms of government and different rules and regulations they're making. One came out last week or the week before, regarding the virtual colonoscopy. Could you guys comment on that, just kind of the impact it could have on radiologist and GI's ability to do virtual colonoscopy, or the desire to at least?

Mike Carrel

I mean obviously we were disappointed by the CMS decision to not recommend that at this point in time, but the impact in our business today is basically nothing. I mean people aren't necessarily buying or haven't been buying and we did not put that into our projections. We don't anticipate, we bundle it mostly into most of the sales that we do anyway.

If it was going to get approved, which we think from a public health standpoint is the appropriate thing to have done, that would be fantastic and we've got great products to serve that particular market. But in terms of the short-term, we were disappointed by it, and we're going to continue support trying to get it approved, again from a public health standpoint.

But from an impact on our business today and 2009, it just wasn't something that we built in, nor did we see any exceptional upside, even if it had got approved.

Michael Cherney – Deutsche Bank

Great, thanks guys.

Operator

Our next question comes from Charles Rhyee – Oppenheimer & Co.

Charles Rhyee – Oppenheimer & Co.

Just a couple of quick ones, I don't know if I missed it but Pete, can you give us the license revenues by Toshiba and McKesson and Direct?

Peter Goepfrich

Yes, $5.2 million for Toshiba, and Direct $2.8 million.

Charles Rhyee – Oppenheimer & Co.

And then for McKesson?

Peter Goepfrich

Marginal, less than $100,000.

Charles Rhyee – Oppenheimer & Co.

Less than $100,000. Okay and also, I think you mentioned before when I'm looking at the – you said something about Toshiba related for the maintenance revenue, there was an adjustment about $300 and something thousand? Can you just kind of go over that, I kind of missed it a little bit.

Peter Goepfrich

Yes, we had an incremental benefit of $391,000 related to Toshiba maintenance and support, billing adjustments for some historic periods. There was some data reconciliation process we went through over the last few months and came to agreement on a balance to be paid for past discrepancies.

Charles Rhyee – Oppenheimer & Co.

And so that kind of explains the jump in the gross margin on the maintenance service line?

Peter Goepfrich

Yes, for the most part.

Charles Rhyee – Oppenheimer & Co.

For the most part.

Peter Goepfrich

There still is leverage in that side. So we would still be gaining some additional margin, particularly with the Vital Enterprise transition. There's higher maintenance rates on Vital Enterprise.

Charles Rhyee – Oppenheimer & Co.

Okay.

Peter Goepfrich

So yes, I would anticipate those margins – they won't deteriorate.

Charles Rhyee – Oppenheimer & Co.

Okay. And then what about on the license side; it looks like the gross margins dropped sequentially. Is that also related to the accounting? I mean because it looks like cost of license revenues jumped up sequentially about $300,000 or so.

Peter Goepfrich

A couple components to that, really Toshiba International revenue was stronger and they generally carry lower margins. So that's probably half point to a point to that. Then the actual Vital Enterprise model results in a little bit lower margin on the license side, another point or so, if not a little bit more.

As we defer more maintenance and support related to that deal and then recognize it over the maintenance and service period.

Mike Carrel

Charles let me – I'll actually clarify something on that.

Charles Rhyee – Oppenheimer & Co.

Sure.

Mike Carrel

Because I think it's important for everybody to know. On the new Enterprise model, we don't recognize as much revenue up front on the license side and it comes back, obviously for we have larger maintenance contracts, higher maintenance pricing that we effectively get for the long-term.

So we carve out more of the license and the booking up front and don't recognize it as much, and that's one of the other reasons you'll see that the decline or the shrinkage on the license line that's coming into some maintenance and services longer term. So it really builds a nice base for a long-term recurring revenue share for us.

Charles Rhyee – Oppenheimer & Co.

Okay, I understand that, but I guess what I'm trying to figure out is because when I look at your cost of license revenues, I mean the cost to deliver it, you've been running about a little over $1 million a quarter and as your revenues grow that's where the leverage comes from, so that number shouldn't be going up, but it just jumped up a little bit.

Should I think of the $1.6 million as sort of the run-rate on a sequential basis as we're going forward, or is there anything unique to that I should think that really the first three quarters of the year is more realistic?

Peter Goepfrich

It's probably a mix between the two. So I'd average them out.

Charles Rhyee – Oppenheimer & Co.

Okay. And the same on the cost of maintenance right is that you're getting the bump on the Toshiba reconciliation and the revenues in part, but when I'm looking at about $2.5 million a quarter on your cost of serving maintenance and services is about consistent then. Is that right?

Peter Goepfrich

That's reasonable. Yes.

Charles Rhyee – Oppenheimer & Co.

Okay. I guess the last question is obviously we're in a tough market and previous question obviously addressed a lot of that. What are you hearing from the equipment makers, like when you talk to Toshiba, how are they viewing the market, particularly the U.S.?

What is the communication you're getting from them in terms of how they plan to address this year versus maybe next year? Any sort of color on that would be helpful.

Mike Carrel

I think they're seeing the same we are in the U.S. market very specifically. I mean they're seeing a downturn on the CT market, they're getting a lot of pricing pressure on their high-end scanners, and so we definitely hear that. People are buying more on the low-end scanners from both Toshiba and from some other people.

We're also seeing a lot of investment in low dose. It doesn't necessarily impact on the financial side but you're seeing GE and Siemens and others come out with really low-dose CT scanners and really pushing that from a marketing standpoint, but other than that, I mean you're just seeing a slow growth on that particular area and they're trying to find out other ways to get revenue outside of the CT and other cycles.

Charles Rhyee – Oppenheimer & Co.

Okay.

Mike Carrel

In the U.S. Now, internationally, we're seeing strength as you've seen in Europe. Obviously, the Japanese economy has impacted sales in Japan. I mean that's even had a harder impact I think on a lot of companies who are selling into that particular market place.

Charles Rhyee – Oppenheimer & Co.

No, that's fair. Maybe the last question here, when you think about your position in the market, obviously, you have a leading solution here but you're sort of still a stand-alone product. I guess two questions to that, we're looking at a lot conversion on PACS and advanced visualization, and you talked about your M&A strategy here.

I mean is the move here to get into PACS as well and provide a complete solution? Is that a possibility? Is that something you're considering?

Mike Carrel

We're not looking at becoming a PACS company. What we believe is that there's been a lot of investment in PACS over the many years, over the last several years, and those companies – so examples are UCLA is one of our top customers. UCLA just implemented a large GE Centricity PACS upgrade. They're not going to replace that.

So what we have to do is we've actually got to build the best system from a platform standpoint that integrates seamlessly into that GE PACS, also integrates into their backend EMR and that is what's absolutely critical from a platform standpoint, and then we can be used kind of as the front end on many of that, on a lot of that and that's exactly what we're doing at UCLA or at a Brigham and Women's, etc., but we're not necessarily looking to replace that PACS from them.

Charles Rhyee – Oppenheimer & Co.

Okay, I mean I understand that but I mean you see other PACS players trying to bring more functionality on the visualization side, right, and you've got like Carestream out there and obviously Philips when they made that acquisition several years ago, Stentor Radiology, they're trying to combine their PACS with their advanced visualization software. And do you find it at a point where you can see a lot of customers saying hey, you know what I can just get a combined solution here. Do you find that becoming an issue at all?

Mike Carrel

I mean clearly, obviously, the players that you just talked about are trying to build advanced visualization into their solutions but our solution is far superior to theirs. We're going to continue to invest to differentiate on the clinical side of it and the accessibility side of it and I think we are far and away ahead of them. That's why we continue to invest R&D dollars into that area, but yes. Obviously they are absolutely trying to build that in, but we're also trying to be way ahead of them, be demonstrably better from them on the clinical side of things and also the accessibility and that's really critical.

Charles Rhyee – Oppenheimer & Co.

Okay, and –

Mike Carrel

And we're seeing that out in the marketplace and we're seeing it at some of our customers. UPMC is another great example that is a Stentor iSite customer of ours. They have attempted to try the advanced visualization solution that was embedded into the Stentor PACS and they are continuing to stay strong with Vital Images for the long term.

Charles Rhyee – Oppenheimer & Co.

Okay, that's pretty helpful and then one last question for Peter. I don’t know if you mentioned it. What was the – I know I see in the press release the cash flow from operations for the full year. What was it for the fourth quarter?

Peter Goepfrich

Two point two.

Operator

Your next question comes from Richard Close – Jeffries & Company.

Richard Close – Jeffries & Company

Mike, I was wondering if you could give us additional details, I think you said something about the sales pipeline doubling; maybe if you could go into more depth on that front. And then how you guys build your '09 guidance in terms of the revenue forecast that you put out there. How confident are you in that number?

And then Peter, I think you talked a little bit about the sales force declining. What kind of impact does that have on your ability to attain your new revenue guidance for '09?

Mike Carrel

All right, so I'll start it. There are obviously a lot of segments to that so if I miss any, Richard, please let me know. So first I'll address the pipeline. The reason I put out the pipeline number for everybody is more just there is a lot of interest, a tremendous amount of interest in our solutions and when we look at the pipeline the pipeline really looks out well beyond 2009. And what it's showing is that there's demand that's going to come beyond 2009.

Again, tough economic environment as we've all talked about in 2009. Bringing it through the pipeline it's a much longer sales cycle than the enterprise side but people are excited about the products that we're bringing to the table. We're not going to talk about the amount that's in there. What I'm trying to just describe and show is the confidence in the long-term fundamentals of the business. Kind of what Michael Cherney was asking earlier as well in terms of getting the levers longer term. So I guess that's the basic comments on the pipeline.

In terms of the revenue build for this year we're confident in the range that we gave $61 million to $66 million. We build it really looking at three major components. The first is our maintenance and services business which obviously continues to grow on a revenue stream and we're carving out more and getting larger contracts on that signed up as we talked about.

Two is we look at the Toshiba commitment that was made for the year and we understand what's going to come in from that and look at the demand and then we do have an exhaustive look at not only our pipeline but the market in general for our direct business to achieve the rest of that. And I'm not going to break it down specifically for that but that's kind of how we look at the business and how we look at the revenue streams to get to the $61 million to $66 million.

And again, what we're focused on this year is we're just saying the U.S. economy is tough. I mean 45% of the hospitals in the U.S. have said they're going to have a spending freeze and what we don’t want to do is we don't want to commit to something when we know that that is happening right now and I think there's confusion over what the stimulus package is going to do.

And so from our standpoint I think hospitals are delaying purchases. As I mentioned our biggest competitor is do nothing out in the marketplace right now. And so what we're saying is we feel confident in the $61 million to $66 million based on where we are today and based on what's happening in the U.S. economy.

Richard Close – Jeffries & Company

Okay and then how does the decrease in the sales force impact that or I mean, just what was the specific decrease in the sales force and when did that occur?

Mike Carrel

Well the decrease in the sales force was similar to the decrease that we did earlier in November. I mean it was in concert with us getting ourselves so that we knew we were going to grow profitability in 2009 in a significant way. And that's exactly what we're doing and that's what we've put in our guidance for everybody as well and from a sales force standpoint we think that the team that we've got in place is fantastic. They can cover the market that exists today and also the market that's going to come back into the 2010 timeframe.

Richard Close – Jeffries & Company

Can you give a little bit more details, I think you mentioned something with respect to gaining the market share and then you guys compiling some data where competitors are down 30% plus or something like that in 2008? Maybe if you can give us more clarity on what your market share was exiting '07 and what you think it is here as we are now in 2009 and some clarity on the other competitors sort of decreasing?

Mike Carrel

Yes, I'm in a couple boats. We had an independent survey done of hospitals greater than 100 beds or more in the U.S. marketplace. We believe exiting 2007 we were a little bit less than 30%. We believe we're greater than 30% market share right now in that particular market. We did finish number one during this survey that we had and showed gains across the board and as I mentioned it's not just the market share part of it.

It was that in that same survey what came out very strongly was that we were the best technology, the best company to work for and we made the most improvements in 2008, so all of those things came out in the survey that was done. I guess that's the first piece.

In terms of just looking at the competition I mean you see the competition in terms of what gets announced by GE and many others and we've been able to verify that our competitors are decreasing at about 30% per year and we've been able to gain some share, both through our surveys and also through what we see out in the marketplace.

Richard Close – Jeffries & Company

With respect to I think you said something in there about market share in hospitals less than 100, obviously that would have been driven primarily from the Toshiba relationship, would it not?

Mike Carrel

No, I said greater than 100.

Richard Close – Jeffries & Company

Okay.

Mike Carrel

Hospital beds greater than 100. There's about 24 hospitals that are greater than 100 beds in the U.S. and its hospitals that were greater than 100 beds not less than 100 beds. And I mean some of our market share gains are based on our relationship with Toshiba and there's no doubt about that. Toshiba continues to do well. They're a fantastic partner of ours. They're somebody that we're very close with and so absolutely they definitely continue to contribute towards our market share gains as well.

Richard Close – Jeffries & Company

Okay, and then with respect to the revenue guidance for the current year, what are you factoring in from the international side of the ledger I guess? Obviously you had a good year on the international front and do you, I mean, have you factored in all the financial strife I guess internationally in Europe specifically and all that? Do you feel like you've factored in that – enough of the pain and suffering that's out there globally into your forecast?

Mike Carrel

I think that in the range that we have, yes.

Richard Close – Jeffries & Company

And then I guess just a final question with respect to if you can give us more details on the margins. When you look at the enterprise side and the gross margins, where do you think this sort of settles out over a three-year period? Where do you guys envision gross margins being two, three years down the road?

Peter Goepfrich

I'll take this, Mike. We don't give longer projections than just this current year, but I would anticipate you'll see a little bit of stress on the margins which is why from our historic highs we brought it down a little bit to this 76, but longer term than that we're not prepared to give that kind of fit. But clearly there's pressure on the enterprise as we move to it as I've talked about before.

Richard Close – Jeffries & Company

And then Peter I think you gave some bookings numbers or you gave some numbers along the enterprise. Can you repeat those for us?

Peter Goepfrich

Oh, the enterprise numbers? Yes, I can. Enterprise orders 4.1 million and it was $1.9 million of revenue, license revenue related to those this quarter. And that's essentially doubled from last quarter, 2.1 and $1 million of license revenue in the third quarter.

Operator

(Operator Instructions) We will take our next question from Ernest Andberg – Feltl & Co.

Ernest Andberg – Feltl & Co.

One of the problems I’ve seen happening out here on our side of the fence is getting annual guidance. We as analysts need to sort of interpret how you think the year is going to progress to get to the annual guidance and if we guess wrong, you guys miss.

Can you give some general idea as to how you think the year lays out on a quarterly basis, as opposed to specifically guiding the quarters?

Mike Carrel

We’re not going to – as you mentioned we’re giving annual guidance, that’s the guidance we’re very comfortable with overall as a business. In terms of the kind of on the quarterly basis, I guess we’ll kind of leave it to you on some fronts. The only thing that I can say is that the report that I mentioned with the American Hospital Association putting out there, that they’re really putting a spending freeze through the first six months of the quarter – first six months of the year in terms of 45% of the hospitals.

And so I think that you’ve got a lot of uncertainty out there in the market place today and I think that’s just a data point for everybody to look at, but our guidance we feel comfortable with for the year.

Ernest Andberg – Feltl & Co.

On the overall revenue guidance $61 to 66 million, I’m interpreting your comments as to the revenue flow from Enterprise, that we should look at softness on the license side of it and better performance on the maintenance and service side of it, build our numbers to the $61 to 66 million?

Mike Carrel

I think that’s a fair commentary.

Ernest Andberg - Feltl & Co.

Okay. Peter, where can we look at your operating expense lines relative to the fourth quarter and thinking about where the absolute numbers or trends might be in ’09?

Peter Goepfrich

I think the only thing that noticeably jumps out every year is when we have RSNA in the fourth quarter.

Ernest Andberg – Feltl & Co.

Okay and then use your guidance in the press release on the overall numbers.

Operator

Our next question comes from Brett Jones – Leerink Swan.

Brett Jones – Leerink Swan

Actually, I want to dove-tail off of the previous caller's question. When we talk about the improvement service and maintenance, I’m really just trying to hone in on – make sure I understand the guidance correctly. If I take run rate the service and maintenance you had for the last quarter and even adjusting for the Toshiba – the one-time Toshiba benefit, I’m looking at about license revenue of down call it 10 to 25%.

Is that about fair for what you guys are expecting for ’09?

Mike Carrel

I’m sorry repeat that again.

Brett Jones – Leerink Swan

I was just taking the Q4 service and maintenance revenue line and I was annualizing that and even stripping out the one-time Toshiba benefit, and then I’m taking that and holding hardware constant and it appears that you guys are projecting – it would imply that your guidance would be projecting license revenue to be down, call it 10 to 25%. Is that about the range that you guys are looking for 2009 for license revenue?

Peter Goepfrich

It’ more like 5 to 20%, but in that range yes.

Brett Jones – Leerink Swan

Okay, 5 to 20% which would mean that essentially service and maintenance – you would assume that service and maintenance is growing slower than what I'm – than the run rate for Q4?

Mike Carrel

Again, let’s just be clear about, we’re giving guidance of $61 to 66 million on the top line and I think that we’ve given the details that we’re willing to give and that we’re comfortable to give right now. We think maintenance and service will be strong.

The way our license is basically being put together, is that we know that we are not going to recognize as much up front as Peter described, he talked about how much we booked in the fourth quarter and then the relative amount that was recognized on it.

You can tell that that’s building a really nice revenue stream, not only for 2009 and 2010, and so I think we’ve given the guidance to hopefully help you guys out in building from your models.

Brett Jones – Leerink Swan

All right. No that’s fair enough. We've talked about the Toshiba agreement a little bit. Are there minimums for all five years?

Mike Carrel

We have a minimum contract yes. It’s a five year contract with minimums in the contract basically successive years.

Brett Jones – Leerink Swan

For each of the five years?

Mike Carrel

Successive years yes. Each year has a minimum amount in the contract.

Brett Jones – Leerink Swan

Okay. So each year there is a minimum purchase requirement. When we think about and this is I’m probably going to – I’m not asking for specific numbers but just directionally when we think about the minimum requirements within the Toshiba market – Toshiba contract, the outlook for the CT scanner at the time this renewal was done versus the last time is significantly worse.

Is it fair to assume that the minimums are going to be – minimum purchases that Toshiba is going to make, is going to be less than what we saw in the previous contract?

Mike Carrel

We don’t comment on the specifics for minimum contract on that front.

Brett Jones – Leerink Swan

But even directionally?

Mike Carrel

Even directionally. We feel very comfortable with the five-year contract, with minimums in each year as you described and feel very, very good about that relationship and where it’s going, plus the offsets on the development side that contribute even more and we don’t comment specifically on how much that’s going to be for us in a given year.

Brett Jones – Leerink Swan

No I understand I wasn’t trying to get the exact amount. I’m just thinking just intuitively, we know that the CT market outlook was materially worse than when you guys renewed it last time, I would assume that’s fair to say?

Mike Carrel

The CT market is clearly worse yes.

Brett Jones – Leerink Swan

All right, and then just lastly, I was just wondering from a, and this is just a technical question, for the VitreaWeb, is any of the functionality – does any of the functionality require using VitreaACCESS or VPNing in, or is it all truly 100% web accessible or a thin client?

Mike Carrel

Our product is a thin client, it's VitreaWeb; it’s a thin client product and is accessible to all of our applications. We no longer sell VitreaACCESS, that’s no longer part of our solutions. So we’ve got Vital Enterprise and as part of Vital Enterprise, Vital Enterprise includes the servers 24 x 7, our service programs that we have out in place, and education programs which are critical and in addition to that, it has VitreaWeb, which allows access to all of our applications by the web.

Brett Jones – Leerink Swan

And none of it is for moding in?

Mike Carrel

Well if somebody is at their house, they're going in and some of that's dependent on the installation very specifically for that institution in terms of whether or not they need to VPN or not. Quite frankly, it is usually indicated by the institution as opposed by our technology.

Brett Jones – Leerink Swan

Okay, so yes I just wanted to make sure the functionality itself was not a limiting factor.

Peter Goepfrich

Correct.

Operator

(Operator Instructions) Our next question comes from Alan Fishman – Thomas Weisel Partners.

Alan Fishman – Thomas Weisel

My first question is just simply, can you talk about how long the Enterprise contract is and kind of given that you're deferring the license margin on that, what’s the length of the contract?

Peter Goepfrich

Vital Enterprise is still a upfront perpetual license with some upfront license revenue. The service and maintenance stream, the ongoing maintenance and support is longer. Typically, there is at least one year included in the contract of maintenance and services, and that’s the maximum, but it’s not like you have a ratable contract.

Alan Fishman – Thomas Weisel

Okay, and then I guess for Mike, you talked about adding additional modalities and kind of expanding the Enterprise imaging solution beyond simply CT and advanced visualization. Can you talk about what modalities you’re interested in adding capabilities for and kind of where you – whether that ties in with any M&A in the future?

Mike Carrel

Well we currently do a lot of CT/MR and PET/CT, and so we’re looking at continuing to advance within those particular modalities and we’re also looking at any modality that will produce images over time and doing advanced work on those modalities, anything from ultrasound to nuke med, etc.

Again that’s much more of a longer vision, not necessarily something that’s getting delivered in this year per say, but it shows that we’re thinking beyond from a platform standpoint beyond just CT/MR and PET/CT, which is traditionally what our products are being used for today.

Alan Fishman – Thomas Weisel

Okay thank you, and then lastly, when you’re selling the Enterprise system are you calling on the hospital radiologist? Or who’s’ – what’s the call point now that this is a broader – you’re really trying to sell a broader suite of advanced visualization to the entire hospital?

Mike Carrel

It really depends on the institution, but you’re going to have a lot of people involved, so many of the influencers are going to be the radiologists, the oncologists, the cardiologists, they are critical, they're usually on the decision making committees, but you’ve also got people from IT, from finance that are also intimately involved, sometimes leading it.

So it really depends on how the hospital or the hospital system is run, for some of the large IDNs they’ve got large purchasing groups that get involved as well. So you really have to be able to navigate and understand who the power players are and who are the decision makers at that particular institution.

Operator

And seeing there are no further questions in queue, I'd like to turn the call back over to you, Mr. Carrel.

Mike Carrel

Great, thank you everyone. To recap, Vital is in a sound financial shape and we’re excited about our opportunities. In 2009 we are focused on accelerating our transformation to an Enterprise imaging solution provider, building our next generation technology, gaining market share in a tough market, driving our growth on the bottom line, and executing on all the above in an efficient manner.

Again thank you very much and thanks for joining us today.

Operator

That concludes today’s conference. I’d like to thank everybody for joining us and have a wonderful day.

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Source: Vital Images Inc. Q4 2008 Earnings Call Transcript
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